Economic activity does not grow in a smooth straight line. It fluctuates around a rising long-run trend in a recurring pattern called the business cycle. Unit 4 is about understanding what drives these fluctuations and how governments respond.
The phases of the cycle
The cycle has four phases. In an expansion, real GDP is rising — output, employment and incomes grow. At the peak, activity reaches its high point and capacity pressures (rising inflation) often appear. In a contraction, real GDP falls — unemployment rises and inflation tends to ease. At the trough, activity bottoms out before the next expansion begins.
What drives the cycle?
The main short-run driver is aggregate demand — total planned spending (C + I + G + (X − M)). When aggregate demand rises faster than productive capacity, the economy expands; when spending weakens, it contracts. Confidence, interest rates, the terms of trade and global conditions all move aggregate demand. The long-run trend, by contrast, is set by the growth of productive capacity (the labour force, capital stock and productivity) — the subject of the final lesson.
Reading the cycle through indicators
Economists identify the phase using key indicators: real GDP growth (the headline measure), the unemployment rate (a lagging indicator that rises in contractions), inflation (tends to rise near the peak), wages growth, and confidence and investment measures (leading indicators). A common rule of thumb defines a "technical recession" as two consecutive quarters of falling real GDP.
Match indicators to phases together.
Classify the phase
For each indicator set, decide the phase and justify it:
- Strong GDP growth, unemployment at a multi-decade low, inflation climbing above target → near the peak.
- GDP growth turning positive again after a slump, unemployment beginning to fall → early expansion (just past the trough).
1. Define the business cycle and describe its four phases.
2. Explain the role of aggregate demand in driving fluctuations in economic activity.
3. Describe the typical behaviour of real GDP growth, unemployment and inflation at (a) the peak and (b) the trough of the cycle.
4. Distinguish between the long-run growth trend and the short-run business cycle, identifying what drives each.
5. State the rule of thumb commonly used to define a technical recession.